Shareholder letters offer great tips from our favorite managers.
By Ryan Batchelor, CPA | 06-29-05 | 06:00 AM | Email Article

By way of disclosure, you should know that most of us on the stocks team at Morningstar are hopeless addicts. We're addicted to stock investing. I, too, am a stock junkie, and I'm hopeful there will be no cure. Stock addicts get particular thrills from listening to professional stock-pickers when they share their investing insight and what they see in the market. Chicago was stock junkie nirvana last week at the 2005 Morningstar Investment Conference. The conference was a great opportunity to listen to some of the top money managers in the world talk about the opportunities and risks that they're finding in today's capital markets. But investors need not wait for an annual conference to get current insight from the pros.

Ryan Batchelor, CPA, is a stock analyst with Morningstar.

Shareholder Letters Are a Great Resource
Mutual fund managers are required to publish quarterly reports, which are usually accompanied by a letter to shareholders, written by the portfolio managers. These letters are available to anyone who's interested on most funds' Web sites. Shareholder letters are often packed with rich content, including: commentary on the current state of the market; investing philosophies; recent stock picks; opinions on what the future may bring; and pretty much anything else the manager wants to talk about. Although a letter is typically written for the benefit of shareholders in a particular fund, it also serves as a great fix for stock junkies who hope to glean some keen insight from investment managers and perhaps pick up a good pick or two along the way.

To get an idea of what some of the best stock-pickers in the world are thinking about today, I've read 15 recent shareholder letters from fund managers--whom I'll refer to as the "Chosen Ones"--and I've summarized some of the key themes that stood out within the various letters. We chose these managers because they have phenomenal long-term track records, and because they tend to write interesting stuff. Although most of these professionals are characterized as "value" managers or "contrarians," I prefer to think of them as simply great investors who follow a philosophy similar to Morningstar's: Only buy shares of good companies that trade at a margin of safety to our estimates of the companies' true worth, or fair value. If you who would like to see the actual letters, links to most of these shareholder reports are here.

 Shareholder Letters from the 'Chosen Ones'
 Ariel 
John Rogers Jr.
 Baron Asset 
Ronald Baron
Andrew Peck
 Clipper Fund 
James H. Gipson
 FPA Capital 
Robert L. Rodriguez
 Gabelli Asset 
Mario J. Gabelli
 Legg Mason Value 
Bill Miller
 Longleaf Partners 
O. Mason Hawkins
G. Staley Cates
John B. Buford
 Oak Value 
David R. Carr Jr.
Larry Coats Jr.
Matthew Sauer
 Oakmark Select 
Bill Nygren
Henry Berghoef
 Olstein Financial Alert 
Robert A. Olstein
 Sequoia 
Robert D. Goldfarb
William J. Ruane
 Third Avenue Value 
Martin J. Whitman
 Tweedy, Browne American Value 
Christopher H. Browne
William H. Browne
John D. Spears
 Weitz Value 
Wally Weitz
 Yacktman 
Donald A. Yacktman
Stephen Yacktman

Common Themes from the 'Chosen Ones'
There were several common ideas that seemed to pop up frequently throughout the various shareholder letters. I've summarized what I deem to be the three most common and most important messages.

Don't Be Afraid to Hold Cash
The most common theme by far among the 15 letters is a general difficulty in ferreting out good bargains in today's markets. Additionally, many managers have sold several of their previous stock picks that have since risen to richer prices. The combination of these factors leads to an inevitable result: The managers have more cash than investment ideas, so cash balances are bloated. Holding excess cash balances in a professionally managed portfolio is usually considered a detriment for many reasons, the most obvious being that it provides very little--if any--return on investment. Additionally, a fund with a large cash position is almost guaranteed to lag a strongly rising stock market.

Our "Chosen Ones" are unfazed by such arguments and insist that maintaining a large cash balance is not a conscious decision. They simply haven't found good enough investment ideas in which to put the money to work. More importantly, these managers emphasize that they are unwilling to deviate from their philosophy of only buying stocks with a large margin of safety to what they think the stocks are worth, just because they have large cash holdings. Every one of these managers would prefer to be fully invested at all times, but they refuse to risk shareholders' money by investing in stocks with an insufficient margin of safety. In my opinion, the increase in cash is strong evidence that these managers are disciplined and stick to their convictions, both critical qualities of a successful investor.

Even though they're holding lots of cash, none of the managers suggested that the markets are egregiously overvalued. Instead, the managers simply stated that bargains are harder to find. At Morningstar, we similarly find that the overall market is not horribly overpriced. Based on our estimates of the fair value for our entire coverage universe of more than 1,500 stocks, we think the market is about 6% overvalued (click here to see our valuation graph showing this relationship). We also agree that bargains are difficult to find with only about 4% of our stocks currently holding a  5-star (consider buying) rating. You can find our fair value estimates for more than 1,500 stocks, accompanied by our analysis of each company, by taking a free Morningstar.com Premium Membership trial.

Even though a dearth of bargains can be a challenge to a stock addict like me, I agree that in today's environment it's a good idea to hold onto cash and wait for a nice "fat pitch" rather than risk striking out by swinging at a marginal idea just for the sake of being fully invested. In the words of James Gipson of the Clipper Fund as he spoke to a colleague, "I have more cash than I have investment ideas. In the future, I am convinced that there will be a time when I have more investment ideas than I have cash." Until that time comes, we shouldn't be concerned about holding cash.

Patience
Although this point could have easily been combined with the first, the word "patience" was quoted so many times that it deserves to be singled out. Patience seemed to be the word of choice when describing the benefits of long-term investing. Using the first point as an example, as most of us know, when you have a large chunk of cash in your possession, you often feel a need to spend it. The "Chosen Ones" admit to feeling similarly, but instead of compromising their investing discipline, they've demonstrated patience by keeping their cash until better opportunities are uncovered. These managers have found that, over the long run, the reward of patience is the "pleasure" of reaping large gains from fantastic opportunities, which far outweighs the short-term "pain" of not staying fully invested at all times.

In another example often described in the shareholder letters, after a stock with a good margin of safety has been identified and purchased, it can take several years for the market to recognize that the shares are undervalued, even if the manager was perfectly right. Patience is a necessary virtue while waiting for the market to come to its senses.

Eliminate the Noise
After the San Antonio Spurs won the NBA title last week in a closely matched battle with the Detroit Pistons, a reporter asked the finals' Most Valuable Player--and one of the best basketball players in the world--Tim Duncan if he was concerned about the negative press he had received up until the final game. Paraphrasing his answer, he responded without hesitation that he doesn't pay any attention to the press because he knows what he's trying to do and as long as he achieves it, he has done his job.

Likewise, the "Chosen Ones," who could be considered the Tim Duncans of the investing world, have shown a unique ability to isolate their investment decisions from the emotions and incessant news that surrounds the stock market and individual stocks. Invariably, when a company's stock trades at a significant margin of safety to what it's worth--which is exactly what these managers and us at Morningstar want to see--it is usually because the firm has come across some hard times. There is typically plenty of bad news in the media and truckloads of fear and uncertainty surrounding the company when the initial purchase is made. However, these "Tim Duncans" do enough homework and find a margin of safety big enough that they confidently know why they're buying a specific stock. And regardless of how much bad press or negativity there is surrounding the stock when it is purchased, as long as it achieves a sufficient rate of return for the risk being assumed, it's a job well done.

I'm personally convinced that no matter how smart a person is, it takes a special kind of personality and temperament to be able to eliminate the noise surrounding an investment decision and have the conviction to stand out from the crowd. Quoting Warren Buffett (I'm starting to feel bad that I didn't include him with the "Chosen Ones"), "Once you have ordinary intelligence, what you need is the temperament to control the urges that get other people into trouble in investing." Obviously, you won't always be right, just as the crowd isn't always right. A final quote from Legg Mason's Bill Miller sums up this point much better than I ever could, "Being wrong is something anyone involved in the capital markets has to get used to . . . There is a difference between conviction and stubbornness, and I promise to try and be sensitive to it."

Final Remarks
Although past performance is never a guarantee of future results, the "Chosen Ones" have had outstanding performance. In that light, it's a great practice to read and heed what these managers have to say. Plus, it's a fantastic fix for all hopeless stock addicts.

A Little Bonus for Fellow Stock Junkies
After digging into the top-10 holdings and some of the recent purchases for each of the 15 funds, I found some stocks in which more than one fund had taken a significant position. Although these names weren't bought yesterday (holdings are from March 31 disclosures), it's always interesting to look at what good stock-pickers are holding and what they've been buying.

With five of the 15 "Chosen Ones" funds holding a significant position in the stock, our winner for the most widely owned company is  Tyco . There were eight other stocks common among the top-10 holdings of at least three separate funds--the exact number of funds is indicated in parentheses in the table below, along with the stock's Morningstar rating and moat rating for each company as of June 28, 2005.

 Common Stocks Among Top-10 Holdings of the 'Chosen Ones'
Morningstar
Rating
Economic
Moat Rating
 Tyco  (5)
Narrow
 Comcast  (4)
Wide
 Yum Brands  (4)
Narrow
 Berkshire Hathaway  (3)
Wide
 Liberty Media  (3)
None
 MBIA  (3)
Narrow
 Telephone and Data Systems  (3)
None
 Time Warner  (3)
Narrow
Data as of 06-28-05.

If you'd like to track and analyze these holdings, click here to create a watch list. Then simply click "Continue," name the portfolio, and click "Done." (If this link does not work, please register with Morningstar.com--registration is free--or sign in if you're already a member, and try again.) This will allow you to save and monitor these holdings within our Portfolio Manager.

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Ryan Batchelor, CPA has a position in the following securities mentioned above: BRK.B Find out about Morningstar's editorial policies.
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